When Money is Tight and Risk is Low, an LLC or S Corp are Less Valuable

People starting a small part-time business have asked me whether they should invest in forming an LLC or S corporation. In short, my answer is generally “no, save your money.”

When you start a business, money is tight. Do you really need to invest in forming a legal business entity? The answer depends on how small or large the business will be in the beginning.

If you are investing significant money or time in the business, or you expect significant profits, you should most likely invest in establishing a solid foundation, which means forming an S corp or LLC.

If you are making a small amount of money from the business (such as a few thousand dollars per year) and the business is not high risk, most business owners would prefer to keep their money instead of spending it legal fees to form an S corp or LLC.

Below is a more detailed explanation.

Question: Should a Part-Time Business be in an LLC or S Corp?

Here is an example of a question I recently received:

In the summer, I mow lawns for several people and a small business. Someone suggested I form an LLC or S corp. Would there be any reason why I would need an LLC or S corp for a small part-time business like this in case something would ever go wrong? For example, there is a remote risk someone could be injured, like if a stone few out of the mower and hit a child. If I should form a business, is that a lot of work or just a little paperwork?

Answer: If the Risk is Low, Don’t Start an LLC or S Corp

In general, the cost of establishing an LLC or S corporation for a small part-time business is probably not worth the benefit.

When I give business law seminars, I often use a small summer lawn mowing business as an example of a business with such low profits and risk that it’s not worth spending the money to register a business entity. When considering the return-on-investment of forming an LLC or corporation for a small business, the risk mitigated is small compared to the cost of forming and maintaining a business entity (e.g. an LLC or S corporation). Said another way, while an LLC would reduce some risk, it would also cost a substantial percentage of the profits derived by the business and require additional time doing paperwork each year.

Personal Liability

Also, each worker in the business is personally liable for their own actions, despite having an LLC or S corporation, so whoever is working in the business would likely have personal liability for an injury regardless of whether they were operating in an LLC or S corporation.

Tax Deductions for Business Expenses

You do not need an LLC or S corporation to deduct business expense on your federal income taxes. You can deduct business expenses on Schedule C of IRS Form 1040. Without an LLC or S corporation, you are a sole proprietor, authorized to deduct business expenses and pay income tax on the remaining profits of the business.

Learn More

Here are articles on setting up an LLC yourself and related information:

Video Transcript

I’m starting a business. Should I do a sole proprietorship, LLC, or S Corp? As a business attorney, I get asked this question all the time. Often it’s by people who are starting a business for their first time. Often they have limited financial resources, and they’re trying to just get pointed in the right direction. So I’m providing this educational video to give you the general framework to make that decision.

First off, a sole proprietor: that’s going to be the easiest. There’s no registration required, there’s no filing fee, that you can get all the tax breaks of a single owner LLC. The one thing you don’t have is what’s called limited liability. As you know, an LLC is called a limited liability company. You don’t get that limited liability. But frankly, a lot of times you don’t care, and here’s why.

Here’s how limited liability works. If you start a business and you accidentally hurt somebody, you’re liable as the individual who hurt them, and then your business is also liable. So limited liability doesn’t protect you here. An LLC provides no protection in that scenario. Well, what if you have a contract on behalf of your LLC and the LLC breaches the contract? Well, in that case you’ll have limited liability. In other words, you won’t personally be liable. The LLC will, but you won’t personally.

Here’s the problem though. Most of the time with big contracts that might result in a breach, like maybe you’re gonna rent some office space, or you want to loan some, borrow some money from the bank, in those cases you’re going to be asked to sign a personal guarantee that makes you personally responsible even if you have a limited liability company. So you can see here, limited liability is important, but it’s not as important when it’s a single individual working in a business. It’s more important when you have employees or contractors, because an LLC or a corporation, both of them equally limit liability to the business entity when we’re talking about the improper acts of employees or independent contractors.

So again, if you’re an individual working in a business, sole proprietor might be a great option, if you don’t need that limited liability. Now, of course, you should always talk with an attorney, but this is general educational information to help you spot issues and have a better understanding of how the law works in this regard.

All right, so let’s say that a sole proprietorship is of interest to you. Do you have to do anything? No. You just start working on your business. Keep track of all expenses and income related to the business. You will be reporting that on Schedule C of your tax return. All business expenses that would be deductible in an LLC are also deductible here in your sole proprietorship. So no tax benefits.

What about an S corp? Well, there is an important tax benefit available in an S corp, which might cause you to lean in that direction, and here’s the idea. In order to understand it, you need to understand how self-employment tax works, also known as payroll tax, depending on the setting. When you work for an employer, you know how FICA, Medicare, Medicaid, and all those withholdings come out of your payroll check? Well, that is a payroll tax. The employee pays about 7.8%, the employer pays about 7.8%. It’s about 15% in total.

Well, think about it: when you’re working for yourself, you pay as the employer, and you pay that as the employee. So in the setting where you’re paying yourself, we call it self-employment tax. In the setting where you’re paying an employee, we call it a payroll tax. Either way, it’s essentially the same thing, the same percentage.

So why does this matter? Because in an S Corp you pay yourself a reasonable fair market wage. So whatever you’d have to pay for an employee, let’s say you’d pay that employee $40,000 per year. Let’s say the business brings in a hundred thousand. So you take home forty thousand as the employee and sixty thousand as the owner. Well, in that case you’re going to pay income tax on all of it, but you’ll also pay self-employment tax on the forty thousand that is your wage as an employee.

Now we’re talking in S corp. The amazing thing with an S corp is you’re not paying that employment tax or self-employment tax on the sixty thousand that you take home as an owner. In an LLC you do. In a sole proprietorship you do. So that’s an important benefit available with an S corp, a strong tax reason if your financials justify actually having to pay out that in an LLC or sole proprietorship.

So as you can see, there are a few different considerations here. First, do you need limited liability? And then second, do you have enough profit after paying yourself a reasonable wage where it would make sense to do an S corp and save that 15% employment tax on the profit portion of the money that you take home? A CPA can help you with this. A business attorney can help you with this.

And if you have questions, you’re welcome to drop them in the questions below. You can also go on to the Facebook group that I have and ask questions there, or search; maybe your question has already been asked and I’ve addressed it. This was Aaron Hall. I look forward to more videos like this with you in the future.